Early stage companies with high growth aspire to gain quick and stable investment in order to survive. Traditional mechanisms of fundraising, including debt and equity investment are becoming less popular given the time, documentation and often disproportionate costs incurred. With the increased availability of private capital and seed enterprise investment scheme (“SEIS”) and enterprise investment scheme (“EIS”) investments for start-ups, the fundraising landscape has changed.
What is an advance subscription agreement?
Investment into a company via an advance subscription agreement (“ASA”) is an equity investment, rather than a debt investment, because the monies being invested cannot be repaid to the investor as cash. An investment via an ASA can be made SEIS/EIS compliant due to the fact that i) the investor’s funds are at risk from the outset and ii) the investor cannot demand the return of their investment because they must be converted into shares in the company.
Why use an advance subscription agreement?
ASA’s provide a useful way for investors to obtain benefits of a convertible debt structure, without the confines of the more traditional convertible loan note (“CLN”). Investment via a CLN is becoming less common in England and Wales because they allow the investor to be repaid their investment prior to the investment converting into shares and the investor cannot therefore claim SEIS/EIS tax relief.
Advance subscription involves an investor transferring funds to a company in return for acquiring a right to acquire shares at a future date (usually the next qualifying funding round). Deferring the valuation process for several fundraising rounds allows the company to raise money faster. Investors often benefit from a higher return on their investment as they usually receive a 10-30% discount to the price per share in the next funding round to compensate for their advance transfer.
HM Revenue & Customs (“HMRC”) is reluctant to release official guidance on ASA compatibility with SEIS/EIS tax relief. However, HMRC has granted SEIS/EIS tax relief for investments via ASAs on many occasions.
The investor must not have any connections with the company that they are investing in for two years prior to the date of their investment, or three years after the date of their investment. ‘Connection’ in this context is not defined but is thought to mean any person entitled to acquire more than 30% of the ordinary share capital in the company.
What should an advance subscription agreement include?
A well drafted ASA will usually include the following key provisions:
- An option for the investor to request that their investment be applied towards the issue of shares on a non-qualifying round.
- A long-stop date to ensure the investment is applied towards the shares regardless of the funding outcome. In order for the advance investment to be a genuine subscription for shares and qualify for SEIS/EIS tax relief, HMRC have confirmed that the long-stop date must not exceed 12 months. The long-stop date should be linked to a long-stop conversion price, which is the price per share that is used for the conversion if there is no funding or exit event to provide a third-party valuation of the company.
- Limited warranties to add protection to the company as in reality, smaller investments to early stage companies are unlikely to require heavy negotiation on warranties.
- Cap on maximum value at which the advance investment will convert into shares. This is so that if the company is successful in achieving a high valuation at the next funding round, the investor does not end up with an unexpectedly low share value.
- A qualifying threshold which sets a minimum size for the round that will trigger conversion, otherwise an investor may wish to wait until another larger investment is made, if a certain funding round is particularly nominal.
In the event that the company does not deliver the returns that investors would have anticipated, the ASA can include provisions to allow the company to improve performance and avoid the frustration of a down round. A company may be able to justify issuing shares at a higher price if it has managed to attract further investment at a higher share price before the long-stop date.
Other considerations when negotiating an advance subscription agreement
The company should consider any other events which would trigger the conversion of advanced funds to shares, in addition to qualifying rounds or the long-stop date, such as the sale of the company.
The company should also consider shareholder pre-emption rights, particularly if shares are going to be issued and allotted in subsequent funding rounds as the existing shareholders may need to waive their right of first refusal.
New investors should consider the terms of the articles of association of the company that they are investing in and the shareholders agreement (if any) as the investor will be subject to these documents once the company has issued and allotted the new shares to the investor.
This area of law is relatively new and is continuing to grow and develop. In our experience is it important for investors and companies to receive specialist legal advice in relation to investments via ASAs and SEIS/EIS tax relief.
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